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Pfizer Working That Working Capital

Last week, Pfizer (NYSE: PFE) released its 10-Q for the third quarter. As an investor in Pfizer, what I'm most concerned about from a financial statement perspective is what's reported on the balance sheet and cash flow statement. Since Pfizer does not provide any of this data when it releases earnings, I typically wait until after the release of its 10-Q to check its performance.

One thing I'd been hoping was that Pfizer's merger with Warner-Lambert would lead to improved working capital management. In addition, I was hoping to see Pfizer focus on keeping its balance sheet and cash flow statement healthy rather than managing the bottom line. So far, the results show some slight improvement.

You should keep in mind that Pfizer accounted for its acquisition of Warner-Lambert as a pooling of interests. As a result, the two companies are treated as if they've always been one. This means that the prior-period financial statements have to be restated. There is, however, no requirement to adjust the prior-period financial statements to reflect the fair market value of the acquired assets. Under U.S. Generally Accepted Accounting Principles (GAAP), historical cost is used.

In contrast, when an acquisition is accounted for as a purchase transaction, the acquired company in essence sees its prior existence terminated with the acquisition. In such a transaction, the financial statements of the acquired entity are restated at fair market value and combined with those of the acquirer as of the date of the acquisition. Under GAAP, there is no requirement to restate any prior-period results.

Upon reviewing the financial statement data found in Pfizer's 8-K filings (found here) to check out its restated financials for 1999 as well as for the first quarter of 2000, here's what I found: On a separate company basis, Pfizer's Foolish Flow Ratio stood at 1.61 in December. After the combination of Pfizer and Warner-Lambert, it fell to 1.43. At the end of the third quarter, Pfizer's Flow Ratio was up again, at 1.55.

The improvement found in Pfizer's management of its inventory and receivables is more encouraging. Over each of the last two quarters, Pfizer's days sales outstanding (DSO) -- accounts receivable / (sales/90) -- was down to 68 days. This is its best performance since the fourth quarter of 1997, when its DSO was 67 days. This means that Pfizer is granting short-term loans to its customers for shorter periods than it had previously. While Pfizer is still taking just over two months to collect on its outstanding debts, this is a trend that I'd like to see continue.

Similarly, Pfizer's days sales inventory (DSI) -- inventory / (cost of sales/90) -- has been just over 200 days for each of the last two quarters, which is the best result I can find since at least 1996. While this figure is on the high side (and also well above the historical performance of Warner-Lambert), it does represent a significant improvement. Pfizer is now coming close to turning over its inventory twice a year (360 / DSI), which likely means that it is losing less inventory to spoilage than it did when DSI was 341 days in the second quarter of 1999.

Pfizer's cash-to-debt ratio has also increased from 0.80 for its stand-alone 1999 balance sheet, to 1.0 at the end of the third quarter. There is, however, one ominous sign: During October, Pfizer registered to sell $2.5 billion of additional debt securities at its discretion.

Although Pfizer's year-to-date Cash King Margin is a disappointing 8.3%, I still find it difficult to understand why Pfizer wishes to add to its already burdensome debt load. While I'd prefer that Pfizer not burden its results with additional interest expense, provided that the interest rate on its debt is low enough, I can understand why it might want to convert some of its short-term obligations to long-term ones, particularly when interest rates are reasonably low. However, I don't want Pfizer borrowing money to buy back stock. It doesn't need to add any more debt to its capital structure.

What I find most disappointing about Pfizer's presentation of its results is the way that it continues to focus so much on the bottom line. If I read Pfizer's results with a skeptical eye, I can view its current quarter's results in a much more negative light than they have been presented in the earnings release. Here's why:

As it did when Trovan had to be pulled from the market last year, Pfizer has chosen to exclude the charges associated with the removal of Rezulin from its operating results. My view is that the role of pharmaceutical companies is to develop, market, and sell drugs that are safe and efficacious. In my view, removing a drug from the market that had been previously approved is a cost of doing business.

I don't believe that the associated costs should be excluded from operating earnings. After all, I don't see Pfizer restating prior-period earnings to remove the profits realized from the sale of such drugs. The Wise are much too generous in endorsing this kind of behavior when earnings season rolls around. As Fools, it's up to us to make our own assessment of such charges.

Additionally, Pfizer spends a lot of time in its earnings release blaming lower revenues on foreign currency effects. I've sat in meetings at companies I've worked for, where officials talked about how to best manage foreign currency issues. Managing currency devaluation is a part of doing business. Rarely will you see companies credit the strengthening of a currency for positive results. They should take a similar view when currency translation has a negative impact on earnings.

One last item -- so far this year Pfizer has recorded $611 million in restructuring charges. As discussed in my column last week, we should keep an eye out to see how much of this charge Pfizer actually incurs.